P3 Performance Strategy

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1 DO NOT OPEN THIS QUESTION PAPER UNTIL YOU ARE TOLD TO DO SO Performance Pillar P3 Performance Strategy Thursday 1 March 2012 Instructions to candidates You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to begin using your computer to produce your answer or to use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or subquestions). ALL answers must be submitted electronically, using the single Word and Excel files provided. Answers written on the question paper and note paper will not be submitted for marking. You should show all workings as marks are available for the method you use. The pre-seen case study material is included in this question paper on pages 2 to 7. The unseen case study material, specific to this examination, is provided on pages 8 and 9. Answer the compulsory question in Section A on page 11. This page is detachable for ease of reference Answer TWO of the three questions in Section B on pages 14 to 19. Maths tables and formulae are provided on pages 21 to 24. The list of verbs as published in the syllabus is given for reference on page 27. Your computer will contain two blank files a Word and an Excel file. Please ensure that you check that the file names for these two documents correspond with your candidate number. P3 Performance Strategy TURN OVER The Chartered Institute of Management Accountants 2012

2 Pre-seen case study Introduction M plc is a long established publisher of newspapers and provider of web media. It is based in London and has had a full listing on the London Stock Exchange since The company has three operating divisions which are managed from the United Kingdom (UK). These are the Newspapers Division, the Web Division and the Advertising Division. Newspapers Division The Newspapers Division publishes three daily newspapers and one Sunday newspaper in the UK. The Division has three offices and two printing sites. Between them the three offices edit the three daily newspapers and the Sunday newspaper. The Newspaper Division has two subsidiary publishing companies, FR and N. FR is based in France within the Eurozone and N in an Eastern European country which is outside the Eurozone. Printing for all the Division s publications, except those produced by FR and N, is undertaken at the two printing sites. FR and N have their own printing sites. Web Division The Web Division maintains and develops 200 websites which it owns. Some of these websites are much more popular in terms of the number of hits they receive than others. Web material is an increasing part of M plc s business. In the last ten years, the Web Division has developed an online version of all the newspapers produced by the Newspapers Division. Advertising Division The sale of advertising space is undertaken for the whole of M plc by the Advertising Division. Therefore, advertisements which appear in the print media and on the web pages produced by the Newspapers Division (including that produced by FR and N) and the Web Division respectively are all handled by the Advertising Division. Group Headquarters In addition to the three operating divisions, M plc also has a head office, based in the UK, which is the group s corporate headquarters where the Board of Directors is located. The main role of M plc s headquarters is to develop and administer its policies and procedures as well as to deal with its group corporate affairs. Mission statement M plc established a simple mission statement in This drove the initiative to acquire FR in 2008 and remains a driving force for the company. M plc s mission is to be the best news media organisation in Europe, providing quality reporting and information on European and world-wide events. Strategic objectives Four main strategic objectives were established in 2005 by M plc s Board of Directors. These are to: 1. Meet the needs of readers for reliable and well informed news. 2. Expand the geographical spread of M plc s output to reach as many potential newspaper and website readers as possible. 3. Publish some newspapers which help meet the needs of native English speakers who live in countries which do not have English as their first language. 4. Increase advertising income so that the group moves towards offering as many news titles as possible free of charge to the public. March Performance Strategy

3 Financial objectives In meeting these strategic objectives, M plc has developed the following financial objectives: i. To ensure that revenue and operating profit grow by an average of 4% per year. ii. To achieve steady growth in dividend per share. iii. To maintain gearing below 40%, where gearing is calculated as debt/(debt plus equity) based on the market value of equity and the book value of debt. Forecast revenue and operating profit M plc s forecast revenue and net operating profit for the year ending 31 March 2012 are 280 million and 73 million respectively. Extracts from M plc s forecast income statement for the year ending 31 March 2012 and forecast statement of financial position as at 31 March 2012 are shown in the appendix. Comparative divisional performance and headquarters financial information The following information is provided showing the revenue generated, the operating profit achieved and the capital employed for each division and the operating costs incurred and capital employed in M plc s headquarters. This information covers the last two years and also gives a forecast for the year ending 31 March All M plc s revenue is earned by the three divisions. Newspapers Division Revenue external Revenue internal transfers Net operating profit Year ended Year ended Forecast for year ending million million million Non-current assets Net current assets 4 8 (10) Web Division Year ended Year ended Forecast for year ending million million million Revenue internal transfers Net operating profit Non-current assets Net current assets 1 1 (2) Advertising Division Year ended Year ended Forecast for year ending million million million Revenue external Internal transfers (145) (151) (162) Net operating profit Non-current assets Net current assets 1 1 (2) Headquarters Year ended Year ended Forecast for year ending million million million Operating costs Non-current assets Net current assets 1 1 (1) Performance Strategy 3 March 2012

4 Notes: 1. The Advertising Division remits advertising revenue to both the Newspapers and Web Divisions after deducting its own commission. 2. The Web Division s entire revenue is generated from advertising. 3. The revenues and operating profits shown for the Newspapers Division include those earned by FR and N. The converted revenue and operating profit from N are forecast to be 20 million and 4 million respectively for the year ending 31 March FR is forecast to make a small operating profit in the year ending 31 March The Board of M plc is disappointed with the profit FR has achieved. Additional information on each of M plc s divisions Newspapers Division FR is wholly owned and was acquired in Its financial statements are translated into British pounds and consolidated into M plc s group accounts and included within the Newspaper Division s results for internal reporting purposes. Shortly after it was acquired by M plc, FR launched a pan-european weekly newspaper. This newspaper, which is written in English, is produced in France and then distributed throughout Europe. M plc s board thought that this newspaper would become very popular because it provides a snapshot of the week s news, focused particularly on European issues but viewed from a British perspective. Sales have, however, been disappointing. N, which publishes local newspapers in its home Eastern European country, is also treated as part of the Newspapers Division. M plc acquired 80% of its equity in At that time, M plc s board thought that Eastern Europe was a growing market for newspapers. The subsidiary has proved to be profitable mainly because local production costs are lower than those in the UK relative to the selling prices. The Newspapers Division s journalists incur a high level of expenses in order to carry out their duties. The overall level of expenses claimed by the journalists has been ignored by M plc in previous years because it has been viewed as a necessary cost of running the business. However, these expenses have risen significantly in recent years and have attracted the attention of M plc s internal audit department. There has been significant capital investment in the Newspapers Division since 2009/10. The printing press facilities at each of the two printing sites have been modernised. These modernisations have improved the quality of output and have enabled improved levels of efficiency to be achieved in order to meet the increasing workloads demanded in the last two years. Surveys carried out before and after the modernisation have indicated higher levels of customer satisfaction with the improved quality of printing. The increased mechanisation and efficiency has reduced costs and led to a reduction in the number of employees required to operate the printing presses. This has led to some dissatisfaction among the divisional staff. Staff in the other divisions have been unaffected by the discontent in the Newspapers Division. Staff turnover has been relatively static across the three divisions, with the exception of the department which operates the printing presses in the Newspapers Division where some redundancies have occurred due to fewer staff being required since the modernisation. Web Division The web versions of the newspapers are shorter versions of the printed ones. There is currently no charge for access to the web versions of the newspapers. Revenues are generated from sales by the Advertising Division of advertising space on the web pages. Some of the websites permit unsolicited comments from the public to be posted on them and they have proved to be very popular. The Web Division is undertaking a review of all its costs, particularly those relating to energy, employees and website development. March Performance Strategy

5 The Web Division s management accounting is not sophisticated: for example, although it reports monthly on the Division s revenue and profitability, it cannot disaggregate costs so as to produce monthly results for each of the 200 websites. The Division is at a similar disadvantage as regards strategic management accounting as it lacks information about the websites market share and growth rates. This has not mattered in the past as M plc was content that the Web Division has always been profitable. However, one of M plc s directors, the Business Development Director (see below under The Board of Directors and group shareholding) thinks that the Web Division could increase its profitability considerably and wants to undertake a review of its 200 websites. Advertising Division The Advertising Division remits advertising revenue to both the Newspapers and Web Divisions after deducting its own commission. In addition, the Advertising Division offers an advertising service to corporate clients. Such services include television and radio advertising and poster campaigns on bill boards. Advertisements are also placed in newspapers and magazines which are not produced by M plc, if the client so wishes. An increasing element of the work undertaken by the Advertising Division is in providing pop-up advertisements on websites. Planning process Each division carries out its own planning process. The Newspapers Division operates a rational model and prepares annual plans which it presents to M plc s board for approval. The Web Division takes advantage of opportunities as they arise and is operating in a growth market, unlike the other two divisions. Its planning approach might best be described as one of logical incrementalism. Increased capital expenditure in 2010/11 helped the Advertising Division to achieve an 11% increase in revenue in that year. The Divisional Managers of both the Web Division and the Advertising Division are keen to develop their businesses and are considering growth options including converting their businesses into outsource service providers to M plc. The Board of Directors and group shareholding M plc s Board of Directors comprises six executive directors and six non-executive directors, one of whom is the Non-executive Chairman. The executive directors are the Chief Executive, and the Directors of Strategy, Corporate Affairs, Finance, Human Resources and Business Development. The Business Development Director did not work for M plc in 2005 and so had no part in drafting the strategic objectives. She thinks that objective number four has become out-dated as it does not reflect current day practice. The Business Development Director has a great deal of experience working with subscription-based websites and this was one of the main reasons M plc recruited her in March Her previous experience also incorporated the management of product portfolios including product development and portfolio rationalisation. There are divisional managing directors for each of the three divisions who are not board members but report directly to the Chief Executive. One of M plc s non-executive directors was appointed at the insistence of the bank which holds 10% of M plc s shares. Another was appointed by a private charity which owns a further 10% of the shares in M plc. The charity represents the interests of print workers and provides long-term care to retired print workers and their dependents. Two other non-executive directors were appointed by a financial institution which owns 20% of the shares in M plc. The remaining 60% of shares are held by private investors. The board members between them hold 5% of the shares in issue. None of the other private investors holds more than 70,000 of the total 140 million shares in issue. It has become clear that there is some tension between the board members. Four of the nonexecutive directors, those appointed by the bank, the charity and the financial institution, have had disagreements with the other board members. They are dissatisfied with the rate of growth and profitability of the company and wish to see more positive action to secure M plc s financial objectives. Some board members feel that the newspapers market is declining because fewer people can make time to read printed publications. Some of the non-executive directors think that many people are more likely to watch a television news channel than read a newspaper. Performance Strategy 5 March 2012

6 Editorial policy M plc s board applies a policy of editorial freedom provided that the published material is within the law and is accurate. The editors of each of the publications printed in the UK and France and of the websites have complete autonomy over what is published. They are also responsible for adhering to regulatory constraints and voluntary industry codes of practice relating to articles and photographs which might be considered offensive by some readers. There is less scrutiny of the accuracy of the reporting in N s home country than in other countries. The Eastern European country in which N is situated has become politically unstable in the last two years. Much of this unrest is fuelled by the public distaste for the perceived blatant corruption and bribery which is endemic within the country s Government and business community. It is well known that journalists have accepted bribes to present only the Government s version of events, rather than a balanced view. There is also widespread plagiarism of published material by the country s newspapers and copyright laws are simply ignored. Corporate Social Responsibility A policy is in place throughout M plc in order to eliminate bribery and corruption among staff especially those who have front line responsibility for obtaining business. This policy was established 15 years ago. All new employees are made aware of the policy and other staff policies and procedures during their induction. The Director of Human Resources has confidence in the procedures applied by his staff at induction and is proud that no action has ever been brought against an employee of M plc for breach of the bribery and corruption policy. M plc is trying to reduce its carbon footprint and is in the process of developing policies to limit its energy consumption, reduce the mileage travelled by its staff and source environmentally friendly supplies of paper for its printing presses. The Newspapers Division purchases the paper it uses for printing newspapers from a supplier in a Scandinavian country. This paper is purchased because it provides a satisfactory level of quality at a relatively cheap price. The Scandinavian country from which the paper is sourced is not the same country in which N is situated. Strategic Development The Board of Directors is now reviewing M plc s competitive position. The Board of Directors is under pressure from the non-executive directors appointed by the bank, the charity and the financial institution (which between them own 40% of the shares in M plc), to devise a strategic plan before June 2012 which is aimed at achieving M plc s stated financial objectives. March Performance Strategy

7 Extracts from M plc s forecast group income statement and forecast statement of financial position Forecast income statement for the group for the year ending 31 March 2012 Notes million (GBP million) Revenue 280 Operating costs Net operating profit (207) 73 Interest income 1 Finance costs (11) Corporate income tax 1 (19) FORECAST PROFIT FOR THE YEAR 44 APPENDIX 1 Forecast statement of the group financial position as at 31 March 2012 million (GBP million) ASSETS Non-current assets 641 Current assets Inventories 2 Trade and other receivables 27 Cash and cash equivalents 2 Total current assets 31 Total assets 672 EQUITY AND LIABILITIES Equity Share capital Share premium 35 Retained earnings 185 Non-controlling interest 16 Total equity 376 Non-current liabilities Long term borrowings Current liabilities Trade and other payables 46 Total current liabilities 46 Total liabilities Total equity and liabilities Notes: 1. The corporate income tax rate can be assumed to be 30%. 2. There are 140 million 1 shares currently in issue. 3. The long-term borrowings include 83 million of loan capital which is due for repayment on 1 May 2013 and the remainder is due for repayment on 1 April End of Pre-seen Material The unseen material begins on page 8 Performance Strategy 7 March 2012

8 SECTION A 50 MARKS [You are advised to spend no longer than 90 minutes on this question.] ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 11, WHICH IS DETACHABLE FOR EASE OF REFERENCE Question One Unseen case material The following information relates to M plc. Web site M plc publishes a Sunday newspaper that is popular throughout the UK. The newspaper has recently launched an online version which can be downloaded by subscribers who pay a monthly fee that is slightly less expensive than buying the printed version of the newspaper. There are approximately 80,000 subscribers to this service. The online version of the newspaper allows subscribers to post comments concerning any of the articles published in the most recent version of the newspaper. This has been a popular facility that readers appear to value. There has been an average of 15,000 posts per week since the posting facility was introduced. Subscribers must log in using their user names and passwords before they can make a post. M plc does not edit such posts because it would be prohibitively expensive to do so. Instead, M plc relies on software that scans each draft post for offensive language and any post that does not trigger that software appears in a text box underneath the article and can be read by all subscribers. Subscribers to the online version of this newspaper must register using a credit card in order to obtain a subscription. They have to tick a box onscreen to acknowledge that they have read and agreed to M plc s terms and conditions, which include the following: Subscribers accept M plc is not responsible for any offensive or incorrect comments posted on the site. Subscribers agree that any posts they place on the site will be honest, accurate and not intended to cause any harm or offence. Authors agree that all responsibility for comments they post remains with the author not M plc. The copyright to all posts to the site belongs to M plc and nobody is permitted to copy, print or publish them for any purpose without first seeking M plc s permission. Last month a post was made underneath an article about J, a famous pop singer, who endorses a range of vegetarian meals. The post s author claimed to have seen J eating a meat dish in a restaurant. The post was read and copied by a journalist from a rival newspaper. The journalist sought reactions from J and the manufacturer of the vegetarian meals and published the story on the front page of the Monday edition of the rival newspaper under the headline Famous vegetarian eats principles. The article was careful to state that the only foundation for the story is the post to M plc s site. J s lawyers have contacted M plc to inform the company that the vegetarian meals manufacturer has cancelled J s advertising contract. J is seeking compensation from M plc for the loss of these earnings and also for the damage to her reputation. M plc has rejected the claim on the grounds that it had taken all reasonable steps to prevent any harm to J s reputation when it drafted its terms and conditions. The offending post was removed from the site as soon as it was drawn to M plc s attention. March Performance Strategy

9 Expenses audit M plc s directors receive monthly management accounts which show major categories of income and expenditure. The level of journalists expenses has been growing dramatically. The Board of Directors has insisted that the internal audit department carry out regular reviews of the journalists expenses starting as soon as possible. The directors also asked the Head of Internal Audit to investigate immediately the increase in journalists expenses. The investigation revealed no evidence of fraud but did uncover a culture in which job-related expenses were being incurred with no regard to the cost. For example, if a journalist wished to conduct an interview outside of a contact s office for the sake of privacy, it had become accepted that the interview would be conducted in an expensive restaurant. Journalists make their own travel arrangements: this was considered to be necessary in order to avoid slowing down work on a breaking story. It had become common practice for all rail journeys to be booked first class and all flights to be taken in business class even though that cost a great deal more than standard or economy class travel. Overnight stays tended to be booked in five star hotels. Journalists had also claimed for items of equipment ranging from mobile phones and laptops to expensive televisions and office furniture for home offices. They usually bought the latest and most expensive technology and justified it on the basis that it would make news gathering more efficient. Expense claims must be submitted on official claim forms with receipts attached. Each claim must be signed by the journalist s editor before the accounts department will process it. Editors told the Head of Internal Audit that journalists attitudes had changed over the past four or five years and that they were making ever more substantial claims. Editors did not wish to risk demotivating journalists by restricting expenses and so spending had tended to escalate. M plc has a formal policy on expenses, with guidance on the maximum costs that can be incurred for entertaining or travel without seeking specific approval. The investigation found that no one in the company has paid any attention to that policy. Wood pulp M plc purchases its paper from a Scandinavian company. Paper is manufactured from wood pulp. Most of the pulp sold in Europe comes from specially grown forests in Scandinavia. Wood pulp is a commodity that is traded around the world at prices set in USD. That means that M plc is quite heavily exposed to fluctuations in the USD exchange rate against GBP because paper is one of the company s biggest expenses. M plc s board reviews its policies on currency risk on a regular basis. It has called for a discussion of three possible methods of managing the company s exposure: Switch to a UK supplier There are three or four UK-based paper manufacturers with which M plc could do business. M plc buys paper in such large quantities that the Production Director believes that it will be possible to negotiate a contract under which the manufacturer will offer a price set in GBP that will be fixed for, say, three years. Invest in USD M plc has a small cash reserve that it can increase by borrowing a substantial amount in GBP. If the resulting balance is deposited in a USD bank account then the interest received will go some way to compensating for the increased cost of borrowing. If the USD strengthens then the deposit will appreciate in value and that will compensate for the additional cost of paper. Take the risk M plc can accept that the price of paper will fluctuate as the GBP fluctuates against the USD. If the movement in the exchange rate is either small or short-lived then M plc s profits will be depressed or enhanced slightly. If the USD appreciates significantly then the additional cost may require the cover price of newspapers to increase. Performance Strategy 9 March 2012

10 The requirement for Question One is on page 11 March Performance Strategy

11 Required: (a) (i) (ii) Evaluate the risks to M plc associated with allowing subscribers to post comments and views on the newspaper website. (10 marks) Recommend, stating reasons, appropriate controls that might be put in place in future to minimise the risks to M plc associated with malicious and inaccurate posts. (10 marks) (b) (i) Explain the importance of a robust control environment for M plc. (3 marks) (ii) (iii) (c) Explain THREE ways in which weaknesses in the control environment appear to have contributed to the problems with journalists expense claims. (7 marks) Explain the difficulties that could arise from the board s directive that the internal audit department should carry out regular reviews of journalists expenses. (7 marks) Discuss the THREE stated possible methods of managing M plc s exposure to movements of the USD against the GBP. Your answer should include an evaluation of the costs and risks associated with each of the three methods. (13 marks) (Total for Question One = 50 marks) (Total for Section A = 50 marks) Section B begins on page 14 TURN OVER Performance Strategy 11 March 2012

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14 SECTION B 50 MARKS [You are advised to spend no longer than 45 minutes on each question in this section.] ANSWER TWO OF THE THREE QUESTIONS Question Two D is currently a large business which sells cars. D was established almost 30 years ago when the founder started buying and selling used cars. The company has expanded steadily since then. It now owns 32 vehicle dealerships that are spread across the country. All of the dealerships now sell new cars. Each dealership has a franchise from a specific motor manufacturer. The dealerships do not compete with one another. Those which sell luxury models are well distanced from one another, as are those which sell more basic models. D has at least one dealership for each of the major manufacturers. All of the dealerships accept customers old cars as trade-ins against the cost of their new car. Trade-in cars are resold at the dealerships if they are less than four years old and are in good condition. If they do not meet these criteria then they are sold through a third party s car auction. It is company policy that each trade-in is serviced and repaired by the dealership that accepted the car from the customer. D s inventory of second hand cars is organised in order to maximise selling prices. Cars are often moved across the country in order to ensure that each dealership has a balanced inventory on offer. High quality luxury cars are sold through the dealerships that specialise in luxury models. Other cars are sorted according to manufacturer. Second hand cars tend to attract higher selling prices if they are sold through a dealership that sells new cars of the same make. The founder of the business remains in place as D s Chief Executive. He has always been closely involved in the day to day supervision of the business but he has now decided to change things. He is thinking about setting up a divisional structure, with four regional divisions for dealerships in the North, South, East and West of the country. Each division will be managed by its own divisional manager and there will be a small executive team based at D s head office to take charge of the business as a whole. The founder s intention is that the divisional managers will be left free to manage without interference from the centre, but performance will be observed and monitored closely. March Performance Strategy

15 Required: (a) The founder has decided that each of the divisional managers will be evaluated using a balanced scorecard system. Recommend, with reasons, TWO measures that should appear under each perspective: Financial Customer Learning and growth Internal business processes (16 marks) (b) (i) Evaluate the potential for dysfunctional behaviour arising from the transfer of trade-ins between dealerships and divisions. (6 marks) (ii) Explain how the problems identified in (i) might be overcome. (3 marks) (Total for Question Two = 25 marks) Section B continues on the next page TURN OVER Performance Strategy 15 March 2012

16 Question Three H is a major travel agent that specialises in holiday travel. H s sales are all made either online or through a call centre. H s primary data processing centre is located in a large office building close to a major city centre. This data processing centre houses the computers and the staff who operate and maintain the website that enables customers to make online bookings. The data processing centre also houses the call centre that handles bookings made by telephone. The website operates continuously. The call centre operates six days per week from 8.00 in the morning until at night. There are 120 call centre operators who work on a two shift basis. The call centre staff work at terminals that are linked through a local network to the same data servers that provide the online service. H s system runs on the standard software package that is used across the travel industry to enable travel agents, airlines and hotels to communicate with one another. All holiday sales are recorded in real-time to prevent overbooking. Data processing is a key part of H s operations. Consequently H has two data processing sites one central and one remote. The primary site is in the city centre and employs 60 systems staff, who operate a three shift system to ensure that the website is always available and up to date. The remote site is located in an industrial estate 40 miles away; it has the same hardware as the primary site. The two sites are linked electronically and data is backed up frequently. There is a full back up every Sunday and incremental backups occur several times every day. The remote site has a small team of systems operators and their shift patterns ensure that there is always at least one of them onsite at all times to ensure that hardware and software are maintained and backups are secure. H s directors decided to test the operation of the backup site by conducting the company s first ever full-scale disaster simulation. The first Tuesday in September is usually the quietest day of the year with a low volume of activity and so that was designated as the test day. All systems and call centre staff were asked to arrive at the primary data processing centre two hours before their normal start time on the test day so that they could be taken to the remote site by chartered buses. The chartered buses would then operate a shuttle service to the city centre site to allow for shift changes and to enable staff to get home at the end of their shift. Systems and call centre staff were warned several weeks in advance that the primary data processing centre would be taken offline at 6.00 on the morning of the test day, immediately after the scheduled incremental backup. The website would go offline at that time. That would simulate a disaster such as a major fire that had disrupted power and communications. It was planned that the systems operators at the remote site would be asked to recreate the data files at 6.30 on the morning of the test day by combining the most recent backup copy with the subsequent incremental backups. The website would be brought back online from the remote site within an hour and the call centre operated from the remote site for a full working day. There was an unexpected 40% absenteeism rate on the day of the simulation, which made it impossible to operate a full service during the simulation. Many of the staff had been concerned that they would find it difficult to travel to and from work at the proposed times because there would be little or no public transport. Furthermore, many would find it disruptive to their childcare arrangements. Almost all of those who were absent ed their supervisors on the day of the simulation to say that they had minor illnesses and that they would return to work next day. March Performance Strategy

17 Required: (a) (i) (ii) (b) Discuss the advantages and disadvantages to H of running a disaster simulation. (8 marks) Discuss the weaknesses of the planned approach taken by H to its simulation. (7 marks) Recommend, stating reasons, ways in which H could ensure that the remote centre would be fully staffed in the event that a genuine disaster occurs. (10 marks) (Total for Question Three = 25 marks) Section B continues on page 18 TURN OVER Performance Strategy 17 March 2012

18 Question Four Q is a Sri Lankan company that manufactures machine parts. Q plans to establish a whollyowned French subsidiary that will manufacture its range of products in France for distribution across the European Union (EU). Q has been established for many years, but it is not widely known outside of Sri Lanka despite the fact that its product range has a very good reputation. Q s Finance Director visited Paris recently in order to discuss the financing arrangements for the subsidiary with a number of French banks. Q could easily borrow the funds at an attractive rate in Sri Lankan Rupees (LKR), but Q s board would prefer to borrow in Euros (EUR). Unfortunately, the French banks felt that they would be taking a risk if they were to back a foreign borrower who was unknown to them and so they either refused Q s loan application or they offered to lend at a high rate of interest. On the flight home the Finance Director entered into a conversation with P, the passenger in the next seat. P is the founder of a French design company that wishes to build a factory in Sri Lanka. All of Sri Lanka s banks have refused to lend to P. One French bank has agreed to make the loan, but at a high rate of interest. P would prefer to raise the finance in LKR and has decided to travel to Sri Lanka in the hope that a face to face meeting with the bank lending officers will be more successful than a negotiation by telephone and . When Q s Finance Director and P realised that they had complementary requirements they started to discuss the possibility of a currency swap that might be mutually beneficial. They each require to borrow the equivalent of 20 million for six years to establish their respective businesses. The current spot rate is LKR to the EUR. Q can borrow in LKR at an annual rate of 9% for six years or in EUR at an annual rate of 12%. A French accountant has told Q that a similar French business would be able to borrow 20 million for six years at 6%. P can borrow in EUR at a rate of 10% for six years. All of the proposed loans would be repayable in one lump sum at the end of the borrowing period. P proposes borrowing EUR 20 million from a French bank at 10%. Q would borrow LKR 3,100 million at 9% from the Sri Lankan bank. The two companies would swap these principal sums and would each pay the interest on the other s borrowings. P is confident that both parties will generate sufficient surpluses from their new foreign operations to raise the necessary currency to meet the interest payments and to accumulate sufficient funds to swap the principal sums back at the end of six years. March Performance Strategy

19 Required: (a) (b) (c) (d) Explain THREE reasons why Q would wish to borrow in EUR in order to finance the proposed French subsidiary. (6 marks) Calculate an estimated LKR to EUR exchange rate at the date of repayment in six years. Note: your answer should include an explanation of your method. (4 marks) Calculate the net present value of Q s cash flows associated with financing if it accepts P s swap arrangements, assuming a required discount rate of 9% and that the anticipated change in exchange rates will occur evenly over the six year period. Evaluate the risks to Q from P s swap arrangement. (7 marks) (8 marks) (Total for Question Four = 25 marks) (Total for Section B = 50 marks) End of Question Paper Maths tables and formulae are on pages 21 to 24 Performance Strategy 19 March 2012

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22 PRESENT VALUE TABLE Present value of $1, that is ( 1+ r ) n where r = interest rate; n = number of periods until payment or receipt. Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% March Performance Strategy

23 Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years Periods (n) n 1 (1+ r ) r Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Periods (n) Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% Performance Strategy 23 March 2012

24 Formulae Annuity Present value of an annuity of 1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum: PV = r [1 + r ] n Perpetuity Present value of 1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV = r 1 Growing Perpetuity Present value of 1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV = 1 r g March Performance Strategy

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27 LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE VERBS USED DEFINITION Level 1 - KNOWLEDGE What you are expected to know. List Make a list of State Express, fully or clearly, the details/facts of Define Give the exact meaning of Level 2 - COMPREHENSION What you are expected to understand. Describe Communicate the key features Distinguish Highlight the differences between Explain Make clear or intelligible/state the meaning or purpose of Identify Recognise, establish or select after consideration Illustrate Use an example to describe or explain something Level 3 - APPLICATION How you are expected to apply your knowledge. Level 4 - ANALYSIS How are you expected to analyse the detail of what you have learned. Level 5 - EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations. Apply Calculate/compute Demonstrate Prepare Reconcile Solve Tabulate Analyse Categorise Compare and contrast Construct Discuss Interpret Prioritise Produce Advise Evaluate Recommend Put to practical use Ascertain or reckon mathematically Prove with certainty or to exhibit by practical means Make or get ready for use Make or prove consistent/compatible Find an answer to Arrange in a table Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between Build up or compile Examine in detail by argument Translate into intelligible or familiar terms Place in order of priority or sequence for action Create or bring into existence Counsel, inform or notify Appraise or assess the value of Advise on a course of action Performance Strategy 27 March 2012

28 Performance Pillar Strategic Level Paper P3 Performance Strategy March 2012 March Performance Strategy